The Lasting, Positive Impact of Sarbanes-Oxley

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Michael W. Peregrine is a partner at McDermott Will & Emery LLP. This post is based on his McDermott Will & Emery memorandum.

Next year will mark the 20th anniversary of the passage of the Sarbanes-Oxley Act, federal legislation that has had an enormous—and mostly positive—impact on the integrity and reliability of companies, their financial statements, leadership and advisors. It sparked the corporate responsibility movement, which continues to impact corporate and leadership ethics and compliance with law. It remains one of the most consequential governance developments in history and serves as an important lesson for corporate officers, directors and their professional advisors.

The act was developed in response to the sweeping instability of commerce and the financial markets following the collapse of several major U.S. corporations in 2000 and 2001 because of financial reporting irregularities, fraud and other contributing factors.
For example, when Enron—once the country’s largest energy trading firm—filed for Chapter 11 protection in December 2001, it became the largest bankruptcy in U.S. history at that time. It was soon surpassed in such ignominy by the July 2002 bankruptcy of the telecommunications firm WorldCom. Several other large corporations met similar fates.

Sarbanes-Oxley was developed in response to the loss of consumer confidence in the capital markets and corporate financial statements arising from these scandals. Congressional hearings identified a series of causes that contributed to the harm, including lax oversight of auditors, the absence of auditor independence, insufficient corporate governance practices, conflicts of interest of stock analysts, limited disclosure obligations and “grossly inadequate” funding of the SEC and its enforcement capabilities.

The resulting legislation contained at least 10 major elements (the bulk of which retain their influence to this day), including:

• The establishment of the Public Company Accounting Oversight Board (PCAOB), charged with the responsibility to exercise independent oversight of the public accounting sector including, but not limited to, the registration of accounting firms and the development of auditing and related attestation standards, quality control and ethics.
• New standards intended to preserve auditor independence and prevent related conflicts of interest, including the prohibition of an auditor performing certain identified non-audit/consulting services contemporaneously with the performance of an audit.
• New responsibilities associated with the formation, composition and responsibilities of public company audit committees; the promulgation by the SEC of rules requiring certification of financial statements by senior executive officers; the prohibition of executive interference in the audit process; and the forfeiture of executive compensation elements in certain circumstances following an accounting restatement.
• New requirements for enhanced financial disclosures associated with transactions that are required to be filed with the SEC, and the establishment of specific internal control mechanisms for financial reporting.
• Direction for the formulation of new SEC rules relating to securities analysts’ potential conflicts of interest, and for minimum standards of professional conduct for attorneys practicing before the SEC.
• The imposition of federal criminal penalties for knowingly and willfully destroying, altering, concealing or falsifying financial records for the purpose of obstructing or influencing federal investigation and retaliating against a corporate whistleblower in certain circumstances.
• Enhanced criminal penalties associated with certain types of white-collar crimes and classification as a felony the failure of an executive to certify financial reports as required by law.

These and other changes had a remarkable impact on corporate governance, including the focus on corporate responsibility and ethics generally; the obligation to exercise oversight of the reliability of financial statements; the importance attributed to oversight of audit and compliance functions; board composition (especially relating to director competencies); the finance committee’s role in preserving accurate financial reporting to the board; and the importance attributed to director independence. Perhaps more thematically important was the gentle shift in corporate control from the CEO to the board.

It should also be noted that these and other act provisions led to significant changes in the professional responsibility of attorneys and were recognized in large part as applicable in concept to nonprofit and private companies.

The initial criticisms of the act were many. It was overbroad, it represented an unnecessary intrusion of the federal government into the financial markets, it represented the federalization of corporate governance, compliance would place severe financial burdens on many smaller companies, and it would depress the IPO market. Over time, the legitimacy of almost all these criticisms faded or failed to materialize.

Indeed, it can be argued that the act has been a great success—it fundamentally changed the relationship between the company and the audit/auditor, enhanced the reliability of financial reporting, established the PCAOB and sparked the corporate responsibility movement, igniting a more robust respect for corporate compliance, fiduciary duty to shareholders, attentive board oversight and ethical behavior—having contributed to limiting the number of financial accounting scandals over time.

A new generation of corporate leaders has entered the boardroom since 2002, and for many of them the magnitude of the financial crisis, its root causes and the impact of the act’s provisions may have faded. As Sarbanes-Oxley’s anniversary draws near, there may be value in leadership education, and perhaps introspection, on how the commerce and governance we know today was shaped by this momentous legislation.